Morrison & Foerster-Enhanced Prudential Standards: The Federal Reserve’s Proposal

Shortly before year-end, the Federal Reserve Board ("FRB") proposed several rules to manage systemic risks presented by bank holding companies with consolidated assets of $50 billion or more and by nonbank financial institutions that are designated as systemically important by the Financial Stability Oversight Council ("FSOC"). The proposed regulation (the "Proposal") would implement the mandatory portions of sections 165 and 166 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act").

The Proposal includes seven sets of requirements for the bank holding companies over the $50 billion mark and the (to-be-designated) systemically important nonbanks (collectively, the "covered companies"): (i) risk-based capital requirements and leverage limits,3 (ii) liquidity requirements, (iii) single-counterparty credit limits, (iv) risk management, (v) stress tests, (vi) the debt-to-equity ceiling, and (vii) early remediation. Portions of the risk management and stress test provisions extend to banking organizations with less than $50 billion but more than $10 billion in consolidated assets.

Highlights

As a whole, Proposal reflects a fair reading of the Act and provides a level of detail that is a two-edged sword. On the one hand, the details in the Proposal are helpful for a covered company to measure its compliance with enhanced prudential standards. On the other hand, the specifics in many of the new standards, including those relating to capital planning by nonbank covered companies, liquidity, restrictions on single-counterparty exposures, mandatory stress-testing, and early remediation, will compel all but the very largest bank holding companies to revisit their risk management systems to ensure that all of the particular requirements have been covered. Areas that warrant careful attention include:

• Capital planning by nonbank covered companies. These companies must re-orient their financial planning to incorporate new quantitative requirements and to take account of all factors that inform capital adequacy.
• Liquidity management. The board of directors and senior management have explicit duties to monitor and manage liquidity, including the development of specific limits on liquidity risk. Certainly covered companies already oversee and address liquidity issues at a high level, but the existing governance structures may not satisfy all of the proposed new requirements.
• Liquidity buffer and the underlying liquidity stress test. The Proposal requires a liquidity buffer that anticipates the proposed liquidity coverage ratio under Basel III. The buffer will be composed of a limited number of highly liquid assets. The size of the buffer is to be determined by complex and virtually continuous stress tests. Covered companies typically have robust models for analyzing liquidity, but the Proposal places some critical parameters around the process that may require significant changes to those models.
• Credit enhancements for single-counterparty exposures. The Proposal has one set of explicit requirements and one implicit set of provisions. Explicitly, the Proposal identifies how a covered company at risk of exceeding exposure limits may avoid compliance issues through the use of credit mitigants. Implicitly, because not all forms of credit enhancement under the risk-based capital rules would qualify asmitigants for the credit risk presented by counterparties, the Proposal suggests that the FRB could begin to take a narrower view of credit enhancements.
• Double stress-testing. As directed by Dodd-Frank, the Proposal requires that both covered companies and the FRB conduct stress tests of the covered companies. Two aspects of the double-testing are important. First, because the tests use essentially the same inputs, the FRB test functions as a test of the validity of a covered company's testing process. Second, the Proposal requires that detailed stress test results be made public on a company-specific basis, which could lead to a variety of adverse market responses to the point that the responses to stress test results could create their own stress conditions for a company. The Proposal's public disclosure requirement, however, is not required by Dodd-Frank.
• Early remediation. Although the substance of the early remediation regime may not differ in material respects from how the FRB currently supervises large bank holding companies under stress, the Proposal identifies several cause-and-effect scenarios that may result in harsher FRB responses to troubled institutions than has previously been the case.

In addition to these core issues, the Proposal discusses a few specific points that could have important operational consequences.

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